Rising money-market rates have forced Federal Reserve officials to take unprecedented steps to maintain control over their key policy benchmark -- and the job is about to get harder. With the Treasury continuing to ramp up bill issuance and the central bank’s balance sheet unwind accelerating, the front-end is poised to take center stage in the second half of the year.

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Last month, in an effort to maintain control of an effective rate that climbed to within just five basis points of their target band’s ceiling, policy makers took the unprecedented step of reducing how much they pay on excess reserves that deposit banks keep at the Fed (the IOER rate) relative to the upper bound of the range.

Chairman Jerome Powell, at the conclusion of the Federal Open Market Committee’s June policy meeting, acknowledged that a burst in bill issuance to plug swelling budget deficits was likely at least partly to blame for fed funds becoming unhinged.

The surge in supply pushed key overnight rates higher, especially in the market for repurchase agreements. As these other short-term assets became more attractive alternatives to lending reserves to other banks, the availability of interbank funding lessened, putting upward pressure on the policy rate.

As the second half of the year gets underway, T-bill supply is poised to expand by another $290 billion, according to JPMorgan Chase & Co. estimates. Deutsche Bank AG expects an additional $185 billion of net bill sales, most of it arriving in the fourth quarter. That’s after about $200 billion of net issuance in the first six months of 2018.

The prospect of increased supply has some saying further tweaks to the central bank’s policy-setting tool will be necessary.

“While no one knows exactly where the funds rate will set, there are reasons to think that it may continue to rise, in which case another adjustment to IOER would be warranted,” said Brian Sack, director of global economics for the D.E. Shaw Group and former head of the New York Fed’s markets desk.

TD’s Goldberg expects the Fed to adjust the IOER rate again as early as its September meeting, and sees fed funds converging with IOER by the end of the year.

Fed Futility
Others argue such policy action will prove futile.

Because the cause of the drift is the result of a glut in short-end supply, only coordination with the Treasury can solve the problem, according to Credit Suisse Group AG analyst Zoltan Pozsar.

“When the Fed’s floor is getting higher, the solution is not to lower the ceiling too, because then markets are going to suffocate and start punching holes in the ceiling, Pozsar said. “I find it odd that the Fed’s response to rising rates is to lower IOER when the issue is about Treasury issuing more bills.”

It’s been less than three weeks since policy makers cut by five basis points the rate they pay on excess reserves relative to the top of their official target range, and the effective funds rate has already crept higher once again. On a number of days last month it settled just three basis points from the IOER rate and eight basis points from the central bank’s upper band. The gap was four basis points on Monday. The culprits, according to Wrightson ICAP, are likely domestic banks that have ramped up their bidding for fed funds. U.S.-based firms took 23 percent of the market share in March, up from an average of 17 percent in 2017